What is Bitcoin and how does it work?

Image source: David McBee

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What is Bitcoin?

Bitcoin, or simply BTC, is the first successful decentralized digital currency—often referred to as a cryptocurrency—and payment system. It was introduced in 2009 by a pseudonymous individual or a group of people known only as Satoshi Nakamoto.

In their nine-page white paper, Satoshi Nakamoto describes Bitcoin as a “purely peer-to-peer version of electronic cash system,” allowing users to transfer online payments without financial intermediaries like banks.

Aside from replacing banks with a P2P payment system that didn’t require third-party confirmation, the mysterious Bitcoin creator launched the currency to address the double-spending problem. In traditional digital payment systems, there is a risk that the same digital token could be spent multiple times. Satoshi Nakamoto created Bitcoin to solve this issue by using a decentralized network to verify and timestamp transactions.

Bitcoin has a limited supply of 21 million tokens, which was intended to create a deflationary system similar to precious metals like gold.

How does Bitcoin work?

Bitcoin is the first well-known application of a decentralized ledger technology called blockchain, which allows cryptocurrency transactions to be verified, stored, and ordered in an immutable, transparent method.

Blockchain acts as a public record, wherein new transactions are confirmed and added to the ledger available for any user to view. Since blockchain is decentralized, no entity controls it. Think of it as an open Google document that updates automatically when a user with edit access adds content. While nobody owns it, anyone with a link can contribute to it.

Bitcoin blockchain is a link of chronologically ordered “blocks” — chunks of code that contain Bitcoin transaction data. Essentially, when someone sends Bitcoin to another person, the transaction is verified and added to the blockchain. This ledger is immutable and transparent, making it virtually tamper-proof.

Network participants in a blockchain can track, assess, and validate Bitcoin transactions in real time. Since Bitcoin has thousands of copies of the same ledger, it requires the entire network of users to unanimously agree on the validity of each transaction.

This agreement between all parties is known as “consensus,” which is achieved through a process called “proof-of-work.”

What is proof-of-work?

The Bitcoin blockchain employs proof-of-work (PoW) as its “consensus mechanism” to validate transactions and secure the network.

Network validators known as “miners” commit to the Bitcoin network by dedicating immense computing power to discover new blocks. When a miner successfully discovers a new block through the mining process, they fill it with 1 megabyte’s worth of validated transactions. This new block gets added to the chain, with everyone’s copy of the ledger reflecting the new data. The miner then gets to keep any transaction fees along with an amount of newly created Bitcoin as a “block reward.” Successfully mined Bitcoins are then stored in a miner's wallet.

Bitcoin users pay a network fee each time they send a transaction before their payment can be queued for validation. The reason behind transaction fees is that they have to exceed or at least match the average fee paid by other network participants. Due to the hefty electricity and machine maintenance costs, validators prioritize transactions with the highest fees to make the most profit possible when filling new blocks.

How to mine Bitcoin

Bitcoin mining is the process of adding new transactions to the Bitcoin blockchain and creating, or “minting,” new Bitcoin. Since Bitcoin uses a PoW consensus mechanism, miners compete to solve mathematical puzzles that validate transactions using specialized computer hardware, such as application-specific integrated circuits (ASICs).

Bitcoin mining is considerably less profitable than it once was. During its early years, it was reasonable to mine Bitcoin from your own home. However, as the computational hardware requirements have grown, miners join mining pools to contribute their computational power to the network.

What is Bitcoin halving?

As the number of transactions increases, the amount miners get paid for each stamp decreases. Approximately every four years, Bitcoin undergoes an event called the “halving.”

During this event, the reward that miners receive for adding a new block to the blockchain is halved. This scarcity mechanism is designed to control inflation and gradually reduce the supply of new Bitcoin until there are 21 million in total.

Bitcoin onlookers estimate that by 2140, all Bitcoin will have been released into circulation, leaving miners to rely on transaction fees to turn a profit from validating the network.

What is a Bitcoin wallet and how does it work?

A Bitcoin wallet is a digital tool used to securely send and receive Bitcoin. It is a digital wallet that stores cryptographic keys—an encrypted type of password—that grants access to a BTC public address and enables transactions.

Bitcoin wallets come in various forms, including software wallets (online or offline), hardware wallets (physical devices), and paper wallets (printed QR codes). Wallets provide security measures like private keys to ensure that only the rightful owner can access their Bitcoin.

When you create a Bitcoin wallet, you will be given private and public keys linked to the digital wallet.

A public key allows you to receive Bitcoin transactions, while a private key lets you access your Bitcoin fund for spending. Think of public keys as your email address that can be shared with anyone. But your private key is like your email password and needs to be a closely guarded secret. Otherwise, you risk getting your account hacked and losing all your Bitcoin deposits.